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Leveraged, Short ETFs Under Attack

Despite soaring assets and popularity among active traders, a number of brokerage firms like Ameriprise, Edward Jones, LPL Financial, Morgan Stanley and UBS have either banned or temporarily halted the sale of leveraged ETFs.

The first iteration of leveraged and short ETFs was introduced in 2006. And from that moment, these particular ETFs have captured the fancy of investors and advisors alike.

In just three years, assets in the ProShares ETFs have ballooned from a few hundred million to $26 billion. After less than a year managing ETFs, newcomer Direxion Shares already has $4.1 billion under management. Rydex SGI has around $2.4 billion in leveraged and short ETFs.

Leveraged ETFs attempt to magnify their performance by twice (200 percent) or three times (300 percent) the daily performance of their underlying indexes. Short or inverse ETFs aim to deliver the opposite or inverse performance of their benchmarks. If a stock benchmark declines in value, a short ETF is supposed to increase in value.

Backlash Begins

In June, the Financial Industry Regulatory Authority (FINRA) issued a regulatory alert warning brokers and advisors about the complex nature of leveraged and short ETFs. As a result of this notice, certain brokerage firms like Ameriprise, Edward Jones, LPL Financial and UBS took steps to halt the sales of leveraged and short ETFs by their representatives.

A lawsuit seeking class-action standing against ProShare Advisors, sponsor of the ProShares ETFs, was filed in August. The representing law firm, New York-based Labaton Sucharow, alleges ProShares violated securities law and didn't properly disclose all the risks associated with its UltraShort Real Estate ETF (SRS) in its prospectus and registration filings with the Securities and Exchange Commission. The suit was filed in the United States District Court for the Southern District.

SRS is designed to deliver double the daily inverse performance of the Dow Jones U.S. Real Estate Index. Over longer time periods, however, it's failed to do so. This is not unusual though, because the impact of index volatility, tracking error and fees compounded over time often causes the longer-term performance of such funds to deviate from daily index returns.

The one-year performance through June 30, 2009 for the Dow Jones U.S. Real Estate Index was negative 42.59 percent. Over the same period of time, SRS has fallen by 79.73 percent. SRS has around $1 billion in assets. While other legal actions may soon follow, the lawsuit has yet to interrupt the operation of SRS.

Because they aim to achieve investment results that usually target the daily returns of their underlying benchmarks, today's leveraged ETFs are probably best suited for investors with a short-term investment time horizon. Since leveraged and short ETFs are principally designed to achieve daily returns, their long-term performance is likely to deviate from the long-term performance of their respective underlying indexes.

Analyzing Results

Let's examine an example of how the performance for leveraged and short ETFs works.

In Figure 1, let's assume you invest $1,000 in two different ETFs: a triple leveraged ETF and a triple inverse performing ETF. Suppose the underlying index increases by 5 percent on a single day. After the market close, the triple leveraged ETF gained 15 percent while the triple inverse ETF lost 15 percent. Both types of ETFs performed as designed.

In Figure 2, let's suppose the index declines in value by 5 percent the following day. Over the entire two-day period the index has lost 0.25 percent. However, the performance for both leveraged ETFs over the same two-day period produces much greater losses of negative 17.25 percent and negative 2.25 percent. This example illustrates how the returns of leveraged ETFs are much more exaggerated and dramatic than their underlying indexes.

Let's assume the same pattern of returns (positive 5 percent one day followed by negative 5 percent the following day) for 30 consecutive days. At the end of 30 days, the index lost 3.69 percent. Interestingly, while both the leveraged long and leveraged short ETFs have opposite daily goals, they both finish the 30 day period with the same 28.92 percent loss.

On July 27, the SEC adopted Rule 204T to eliminate what it called "abusive" naked short selling. With normal short selling, traders borrow stock and sell it, hoping to profit by purchasing the shares later at lower prices and collecting the difference. In naked short selling, traders generate sell orders on stocks without borrowing the shares. While the actual impact of naked short selling on the broader market is not known, the new ban ends share delivery failures and the operational headaches they caused.

The SEC's Rule 204T for naked short selling does not apply to market makers involved in legitimate hedging, nor does it apply to leveraged short ETFs.

"The ban will not impact leveraged index funds at all as they do not short single names and never engaged in naked shorting of any kind," said Daniel O'Neill, chief investment officer at Direxion Funds, sponsor of the Direxion Shares ETFs. He continued, "Leveraged index funds do not have direct short positions -- they use index derivatives to get exposure."

Wall Street Reaction

The negative publicity surrounding them still hasn't quelled investor's appetite for leveraged and short ETFs.

At the end of June, the two largest providers of these specialized ETFs (ProShares and Direxion Shares) amassed $30.2 billion in such funds.

Despite soaring assets and popularity among active traders, a number of brokerage firms like Ameriprise, Edward Jones, LPL Financial, Morgan Stanley and UBS have either banned or temporarily halted the sale of leveraged ETFs. Firms say this stance against leveraged ETFs is because they aren't compatible with the long-term investment objectives of their clients.

One untouched issue is the consistency of investment advice coming from Wall Street brokerages. Have the same brokerage firms that have publicly stopped the usage of leveraged ETFs taken a similar stance against other leveraged products, like hedge funds, closed-end funds and structured products? And if not, why? Shouldn't all leveraged products get the same sort of treatment?

For example, it's a widely known fact that leveraged ETFs are used by many hedge fund managers. Wouldn't it be sinister irony if brokerage firms are still allowing their advisors to recommend hedge funds that are using banned leveraged ETFs? Such inconsistencies should be addressed at the firm level and perhaps even at the regulatory level. Double standards should not be allowed to exist.

Finally, in an August regulatory alert, FINRA said, "The best form of investor protection is to clearly understand leveraged or inverse ETFs before investing in them."